Cost Benefit Analysis and the Environment*
What is Cost-Benefit Analysis?
Cost-Benefit Analysis (CBA) originated in the area of research called welfare economics. It helps to answer questions about the benefit of one outcome over another, from a societal standpoint. Welfare economics uses criterion from the Utilitarian philosophy of the eighteenth century. These researchers tried to "compare outcomes on the basis of what gives the greatest benefit to the greatest number of people. Benefit here means utility: thus, welfare economics looks at ways of comparing outcomes in terms of their contribution to the utility of the population as a whole" (Hanley, 69). The value of environmental costs and benefits are most clearly understood when represented in monetary units, and then balanced against one another.
Stages of Cost-Benefit Analysis:
1. Defining the Project or Policy As well as identifying the choice that will be analyzed, economists must recognize whose welfare is being considered and the time period in question.
2. Identifying Physical Impacts of the Policy or Project Identify (in units) the implications of the outcomes. Examples of this would include: 500 human labor hours required to carry out the project or 3 billion tons of reduced landfill pollution
3. Valuing Impacts Value the impact of a specific action or inaction in terms of its marginal social cost or marginal social benefit. For in-depth information on valuation, follow the link.
4. Discounting of Cost and Benefit Flows A very important concept to realize with CBA is that a benefit is considered more valuable the sooner it is received. In the same way, a cost is considered less detrimental the further way in time it is incurred. For this reason all costs and benefits must be discounted to reflect present values. It would be inappropriate to compare receiving one million dollars today and receiving one million dollars in 75 years as being equal. A discount rate is used to translate future values into present values.
5. Applying the Net Present Value Test Net Present Value (NPV) equals the sum of the benefits in present value minus the sum of the costs in present value. The project should be accepted if the NPV>0. In other words, if the discounted benefits is greater than the discounted costs, the project should be accepted.
6. Applying Sensitivity Analysis Analysis of this kind refers to "recalculating NPV when the values of certain key parameters are changed" (Hanley, 79). Since there is uncertainty in CBA it is important to know for which parameter the NPV is most sensitive. An example would be if a firm installs 3 filters to reduce water pollution and the pollution is reduced by 30%. Sensitivity analysis would look at the affects of a change in the number of filters. If 4 filters reduced the water pollution by 70%, that would be a very large indicator that the percentage of water pollution is very sensitive to the number of filters. Hanley refers to the common parameters that should be reviewed which include:
Advantages of CBA
Problems and Questions that Arise when Applying CBA to the Environment:
*The information in this section was summarized during a study of the following text: Hanley, Nick, and Jason F. Shogren and Ben White. Introduction to Environmental Economics. New York: Oxford University Press, 2001.